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There’s nothing like seeing the good guys score a goal. We have two this evening. One is a win by David Sirota, whose reporting on San Francisco’s plan to shift up to 15% of retiree funds into hedge funds appears to have led to a climbdown by the city. Sirota uncovered an unreported conflict of interest by the consultant recommending the change, who also operates a hedge fund of funds. Admittedly, CalPERS’ recent announcement that it was exiting hedge funds entirely also put pressure on the city to reverse course.
But Gretchen Morgenson collected an even bigger scalp in the form of Blackstone halting a practice that she highlighted in a May article: that of taking “termination fees” when portfolio companies are sold. However, as we discuss later, as positive as this move appears, this is almost certainly Blackstone throwing a big, visible bone to investors in the hope of deterring an SEC enforcement action.
Understand how this scam worked. Portfolio companies are made by their new private equity overlords to enter into various agreements that require them to pay fees to the private equity fund manager, aka the general partner.
Limited partners, as in the fund investors, over time wised up to how much was being taken out of companies the private equity funds by the general partners, and pushed back. The concession was to have the big fees that the investors knew about, which were the “transaction fees” and “monitoring fees” rebated against the annual management fee the investors were paying (note that since the amount rebated is limited by the amount of the annual fees, this isn’t an ideal solution, but we’ll skip over that).
However, the only fees the limited partners got rebated were ones that were specifically identified in the limited partnership agreements. We’ve pointed out, as has the SEC, how much these contracts fail to do a good job of protecting investor interests. One of the ways is that the do not require the private equity funds to disclose all the fees and expenses that they charge to portfolio companies.
Morgenson’s article focused on one of those sneaky non-disclosed, and therefore not shared fees, the so-called “termination fees”. In her story, “The Deal’s Done. But Not the Fees,” she explained the ruse: when a private equity portfolio company is sold, all of the future monitoring fees come due in a one-time, present value payment. This payment is not shared with investors and thus reduces the proceeds of the sale. The example she used was from a so-called club deal, a company called Biomet purchased Blackstone, Goldman, KKR, and TPG.
The chart below, from her story, gives a more general picture of how this scheme worked.
And remember, this was simply one type of non-disclosed fee that the New York Times reporter unearthed. The SEC’s Andrew Bowden strongly suggested that this may not be the only type of covert fee:
“In some instances, investors’ pockets are being picked,” Andrew J. Bowden, director of the S.E.C.’s office of compliance inspections and examinations, said in a recent interview. “These investors may be sophisticated and they may be capable of protecting themselves, but much of what we’re uncovering is undetectable by even the most sophisticated investor….On money moving from the portfolio company to the adviser,” he said, “there is not a level of transparency sufficient to allow investors to protect themselves, no matter how smart they are.”
Morgenson discussed another type of abuse that the Wall Street Journal had previously highlighted, that of private equity firms hiring contractors or affiliates to provide services that investors thought were part of the general partner’s overhead. Instead, these costs are billed as expenses to the portfolio companies. The Wall Street Journal did in-depth reporting on an extreme example, that of KKR’s captive consulting firm Capstone; Morgenson exposed other examples of the same practice, along with other forms of grifting, such as having the funds pay for family members to travel on private jets (remarkably, that provision is usually disclosed in the limited partnership agreements and investors fail to protest, a proof of how badly captured they are). The Financial Times followed with a story on fee on the unseemly magnitude of fees that firms like KKR are taking out of portfolio companies.
We’ve been told that investors are disturbed about the idea that they may be having fees stripped out of their investments in ways that are hidden to them. But most have convinced themselves that they have to invest in private equity funds, so unless they work in concert, or an an industry leader like CalPERS takes action, the odds that any one firm will rock the boat is low.
Thus aside from the media, the most likely source of pressure is the SEC. The agency’s initial salvo, calling out bad practices in remarkably specific detail, is almost unheard of among regulators. However, the agency appears to be quietly retreating, in the apparent naive hope that the private equity firms will clean up their behavior. The reality is that the most likely outcome is that they will make token concessions and paper up future deals more artfully.
Thus as encouraging as the Blackstone climbdown on termination fees appears to be, it’s almost certainly a strategic sacrifice in the expectation that a few earnest-looking moves will forestall SEC enforcement actions. Key details from the Wall Street Journal story:
The world’s largest buyout firm will curb a controversial fee practice that is under scrutiny from regulators and investors…
The shift could save Blackstone fund investors tens of millions of dollars, and cost Blackstone the same amount in the process, and represents a significant U-turn in a long-standing industry practice. Blackstone’s move follows criticism this year from a senior Securities and Exchange Commission official about the practice and could put pressure on other private-equity firms to follow suit, industry executives said.
At issue are consulting payments typically known as “monitoring fees.” Blackstone and other large private-equity firms often enter into contracts with companies they buy to earn these fees for a set number of years, often a decade or longer.
If a company is sold or taken public before then, the contract often dictates that the company “accelerate” the remaining fees, by paying a lump sum for years of future consulting work the private-equity firm won’t have performed.
Blackstone’s accelerated-fee practice was “not helpful” to the firm’s relationship with fund investors, according to a person familiar with the matter. The firm made changes partly because of the bad perception it could engender, this person said.
Blackstone no longer will collect these additional fees after divesting companies it buys in the future, this person said. When Blackstone gets such fees from companies already in its portfolio, the buyout firm will distribute them to investors or cut other fees by a commensurate amount.
While this is a positive step, let us not kid ourselves. The Blackstone protest that they wanted to appease investors is unlikely to be the operative truth. The giant buyout firm, along with other private equity firms who charge termination fees, are vulnerable to SEC enforcement actions on this very practice. The SEC could not only assess fines, but could potentially order the repayment of past termination fees if the SEC felt they were an impermissible or abusive practice. Thus Blackstone is hoping to give the SEC a media win while retaining its past questionably-gotten gains.
So continue to beware of Greeks giving gifts. Private equity firms never give free concessions. This climbdown strongly suggests that Blackstone saw the odd of an enforcement action as high and wanted to give the SEC an easy way out.